October 25, 2010

The Great Recession and Its Aftermath from a Monetary Equilibrium Perspective

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Modern macroeconomists in the Austrian tradition can be divided into two groups: Rothbardians and monetary equilibrium (ME) theorists. The name for the latter is somewhat misleading, however, as both groups argue that monetary equilibrium is ultimately achieved where the quantity of money supplied equals the quantity of money demanded. The difference between these two approaches concerns what should adjust so that equilibrium is obtained. Rothbardians argue that “any supply of money is optimal,” provided only that it is above some trivial minimum necessary to conduct transactions (Rothbard 1988: 180). Because Rothbard’s proposal for 100 percent gold reserves ties the money supply rigidly to the supply of gold, Rothbardians effectively hold the money supply constant in the short run and thereby rely on price adjustments to bring about monetary equilibrium in the face of changes in the demand for money.

In contrast, monetary equilibrium theorists argue that an ideal monetary system would expand or contract the supply of money to prevent changes in the demand to hold money from affecting its current value. Whereas price changes are typically desirable to clear markets for goods and services, ME theorists note that money is unique in that it has no price of its own. Because money is one half of every exchange, changing “the price of money” to clear the money market requires changing all prices. The economy-wide price changes necessitated if the price level is to bear the burden of adjustment disrupt the process of economic coordination and lead to macroeconomic instability and either a deflationary recession or inflation and a potential boom-bust cycle. These significant costs of changing all prices to reflect a change in the demand for money are not offset by a corresponding benefit. As such, ME theorists hold that a system under which the supply of money could be reliably counted on to respond to changes in the demand to hold money would be much preferred over a system where the price level bears the burden of adjustment.

The monetary equilibrium approach should not be confused with the standard neoclassical position of price level stability. Both the Rothbardian and ME approaches recognize that prices—and, as a result, the aggregate price level—should fall in response to increases in productivity. Similarly, if goods become more scarce on average—as a result of a natural disaster, for example—the aggregate price level should increase to reflect this. ME theorists do not advocate stabilizing an aggregate price level. Rather, they suggest changing the money supply to offset changes in money demand and allowing the price level to move inversely to changes in productivity. One can characterize this as a desire to keep the MV side of the quantity equation constant, and allow P to move inversely to Y. It is from this perspective that we consider the events of the last few years and offer policy recommendations for the present and future.

Our approach finds its roots in the work of Knut Wicksell, Ludwig von Mises, and Friedrich A. Hayek. These authors claimed that an excess supply or demand for money causes the market rate of interest—that is, the rate that banks charge on loans—to diverge from the Wicksellian natural rate of interest. Entrepreneurs react to these faulty price signals by altering their investments, lengthening or shortening the production process in line with the prevailing interest rate. The resulting malinvestments—to use the Austrian term—are fundamentally at odds with the underlying time preferences of individuals and will eventually reveal themselves as mistakes, leading to the process of self-correction that is the recession that follows the boom.

We argue that the primary source of business fluctuation observed over the last decade is monetary disequilibrium. Additionally, we claim that unnecessary intervention in the banking sector distorted incentives, nearly resulting in the collapse of the financial system, and that policies enacted to remedy the recession and financial instability have likely made things worse. Finally, we offer our own prescriptions to reduce the likelihood that such a scenario occurs again. Those come in two stages. First we suggest some changes to the way monetary policy and banking regulation are conducted under the assumption that we continue to have a central bank in more or less the form that the Federal Reserve System takes in the United States. We conclude by offering a more radical solution that involves a change in the monetary regime, specifically a move toward a truly competitive free-banking system.